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More and more nonprofits have for-profit subsidiaries. Now one CFO wants to turn that model upside down.

1Aug

It's a question many successful private companies face: how to finance the next stage of growth. Initial public offering? More private equity? John W. Gillespie, CFO of The Mentor Network, a residential-care provider, has another idea: find a large nonprofit foundation with a similar mission to buy the company.


The idea, he admits, is highly speculative. Outside of the hospital industry, it's rare for a for-profit company to peddle itself to nonprofits as an acquisition target. Even if it were common, few foundations are large enough to absorb a company the size of Boston-based The Mentor Network, which has grown to more than half a billion dollars in annual revenues.


And that's not to mention the regulatory and tax changes that might be necessary for a deal of such scale. "I'd put the chances of it happening in the low single digits," says Gillespie. "But it's worth exploring." For one thing, Gillespie, a former investment banker, is less than sanguine about the prospect of going public in the era of the Sarbanes-Oxley Act. And while he's pleased with his company's private-equity owner, Chicago-based Madison Dearborn Partners, he can envision a day when The Mentor Network will outgrow the private-equity market.


Indeed, he says, with government shifting more social services to nonprofits and to firms like his, "we have a responsibility to look at the best way to do it." For The Mentor Network, an infusion of equity capital from a single, like-minded owner would simplify the capital structure enormously. "We are already mostly owned by nonprofit institutions," explains Gillespie, referring to the dozens of college endowment and public pension investment funds that are invested in Madison Dearborn's private-equity fund. Instead of paying dividends to that hodgepodge of "quasi-parent" nonprofits, he says, why not find just one that shares The Mentor Network's mission?



Scaling Up

There is precedent for Gillespie's idea. From museum gift shops to Girl Scout cookies, many nonprofit organizations have profit-making ventures. Increasingly, those ventures are set up to not only generate revenue but also advance their parents' underlying social goals.


To date, The Mentor Network, which provides care and shelter to the developmentally disabled, brain-injured adults, and children at risk for neglect or abuse, has followed a different path. "Social entrepreneurship" is based on the idea that a humanitarian mission is achieved most efficiently if it is supported by scale and a profit motive. "Upstreaming" those profits to a single charitable foundation instead of investors, says Gillespie, would create a "hybrid model" that preserves the business drivers of his company while simultaneously supersizing a practice already common in the nonprofit world.


"We have a number of for-profit subsidiaries," says Frank Gatti, CFO of Educational Testing Services. Best known for offering such academic tests as the SAT, the Princeton, New Jersey-based nonprofit also provides professional licensing exams for architects, financial planners, and others. Those exams don't meet ETS's academic mission, as defined by the Internal Revenue Service, and thus are offered by for-profit subsidiaries.


For any nonprofit buyer of a for-profit enterprise, one key issue is preservation of the nonprofit's precious tax-exempt status. Nonprofits typically must pay unrelated business income (UBI) tax on revenues not directly related to their mission. For example, says Walter Flaherty, CFO of New England Aquarium in Boston, "If the gift shop sells a T-shirt that doesn't have the Aquarium's name on it or a pencil without our logo, we allocate the expenses and create a tax return."


A big question for nonprofits: at what point does such income begin to threaten tax-exempt status? Even for smaller nonprofits, IRS rules are vague. The rule of thumb is that once UBI reaches 15 percent of revenues, a nonprofit should consider setting up a for-profit subsidiary. "The IRS uses revenues as a metric, even if profit is negative or zero," says Gatti. "So the CFO's traditional intuition of materiality doesn't apply."


For Gillespie, of course, for-profit status is less a tax consideration than an essential part of The Mentor Network's business model. But given the size of his firm's revenues, it's not clear what the implications would be for a nonprofit parent. It's likely the parent would need to be massive by nonprofit standards, both to provide the level of investment Gillespie needs and to avoid raising red flags at the IRS.


IRS rules about keeping for-profit subsidiaries at arm's length also are strict, and likely to get stricter as Congress cracks down on abusive use of tax-exempt status. For example, even treasury functions that would be standard at a public company, such as sweeping cash from subsidiaries into a concentration account, are forbidden. "We have to set the whole system up in miniature [for the subsidiary]," says Gatti. Profits can be returned to ETS only in the form of regular dividends.



Balancing Act

Despite such restrictions, nonprofits frequently seek to diversify their revenue these days to make up for government funding cuts and a tightening of foundation grants, says Cynthia W. Massarsky, co-deputy director of the Partnership on Nonprofit Ventures in Englewood Cliffs, New Jersey. Sponsored by the Yale School of Management, the Goldman Sachs Foundation, and the Pew Charitable Trust, the Partnership runs a competition for nonprofits hoping to launch for-profit ventures, offering financial awards and consulting services to winners and, as important, helping weed out ideas likely to fail.


Similarly, several business school competitions — notably the Global Social Venture Competition (GSVC) — invite students to submit business plans for for-profits with humanitarian goals. The GSVC is sponsored by the Haas School of Business at The University of California-Berkeley, Columbia Business School, London Business School, and the Goldman Sachs Foundation.


Gillespie's concept would marry these two initiatives on a grand scale, creating a for-profit, humanitarian business venture owned by a nonprofit parent. "A lot of people are thinking creatively," says Warren Tranquada, managing director of West Orange, New Jersey-based Pepin, Tranquada & Associates LLC, which consults with nonprofits.


In some circles, says Tranquada, the sharp distinction between the nonprofit and for-profit worlds is fading, with the emphasis shifting to "mission-oriented" organizations. "If you look at the sector with that broad view, the issue of capital structure really becomes a tactical decision." Indeed, he says, that is the view at many business schools today, citing the Harvard Business School Initiative on Social Enterprise as one example in which social missions by both non-and for-profit companies are encouraged.


"I definitely think the lines are blurring," agrees Evan Hochberg, managing director of Community Wealth Ventures Inc. (CWV) in Washington, D.C. "I don't think the only strategic decision point is tax status." Gillespie's idea is "very cool," he says. "I can't see conceptually why it couldn't work." Hochberg would know — his firm is a for-profit consultancy with $1.4 million in revenues that is wholly owned by nonprofit Share Our Strength, which combats hunger through marketing programs with for-profit firms. CWV consults with other nonprofits as well as corporations about how to use such programs to advance their own missions. Like Gillespie, Hochberg believes firmly that the discipline and perception of being a for-profit is critical to his business model. "Our charter is to run a profitable business. Yes, we are a social-purpose business, but we're not a nonprofit."


George Soule, spokesman for the Rockefeller Foundation in New York, says Gillespie's idea sounds "interesting," although he says, "we have never considered anything like that." But, he adds, the foundation does have "a very modest program" called Program Venture Experiment (ProVenEx), which invests in financially self-sustaining enterprises intended to advance the foundation's goals. For example, ProVenEx invested $3.65 million in Philadelphia-based Biosyn Inc., which is developing an affordable biopharmaceutical product to prevent HIV transmission.


Balancing social and financial investment, of course, is tricky. While ProVenEx investments are intended to be profitable, they are managed separately from the careful investments used to perpetuate the Rockefeller Foundation's corpus. Gillespie suspects the boards of existing foundations are likely be more risk-averse, but he thinks there may yet be a wealthy entrepreneur out there who is willing to give his model a shot. "Going back to Carnegie and Ford," he says, "there is a long tradition of people who were very creative and innovative in business and then later applied what they learned toward social services or education."

Tim Reason is a senior writer at CFO.

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